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Finance Notes© 2009
J.V. Rizzi
© COPYRIGHT J.V. RIZZI
FINANCE NOTES
I
Finance Overview
A.
B.
Main Decisions – finance, valuation and governance
1.
Objective Function: what are we to maximize?
2.
Investment Decision: how do we invest and manage and why?
3.
Dividend Decision: level (and form) of funds returned to the shareholders?
4.
Capital Structure: how do we fund ourselves?
5.
Governance: who decides? Firm substitutes authority for prices.
Fundamental Building Blocks
1.
Efficient Capital Markets - price behavior in speculative markets.
2.
Portfolio Theory - optimal security selection procedures.
3.
Asset Pricing Models - determining asset prices by investors
utilizing portfolio theory. Replicate complex securities through
arbitrage free strategies involves simple instruments.
4.
Option Pricing Theory - pricing of contingent claims.
5.
Agency Theory - incentive conflict when benefits are concentrated but costs are disbursed.
Heightened by moral hazard when you cannot observe behavior. Enhanced by behavioral bias.
a)
Complex Adaptive Systems
Efficient learning
Information asymmetries: heightened conflict between agent/mgnrs and principals/investors
1. Chance vs uncertainty
2. Ignorance vs adverse selection
3. Dishonesty vs moral hazard
Note: SOX criminalizes agency conflicts
b)
Moral hazard = f (private benefit from misbehaving, 1/verification)
(1) Insufficient effort
(2) Over invest
(3) Entrenchment
Properties
Before
After
Behavior Adverse
Monitoring cost
Selection
Moral hazard
(4) Self dealing
(5) Excessive Risk Taking
c)
Adverse selection
d)
Responses
(1)
Signaling – debt level, dividends, reputation
(2)
Incentives
(3)
Monitoring
(4)
Contracts – warranties, deductibles, pricing
Disbursement
1
FINANCE NOTES
e)
(1)
Value – may not be externally determined
(2)
Financing – agency problems/concerns may deprive firms form financing. Borrowers
may make concessions to lender to achieve funding
(3)
Pecking order: chose financing with lowest assymmetrics/discount
6.
Game Theory: economics of decision making; uncertainty lies in the intention/reaction of others.
Focus on how individuals behave, anticipate and respond. Components – players, action, motives,
and rules.
7.
Behavioral Finance: prices influenced by herd vs. lead steers. The issue is whether markets are
inefficient or just noisy. Requirement: arbitrage limit + learning disability
a)
8.
C.
Value implications – wedge between value and income pledge, between opportunity and
financing
Bias:
Optimism
Over confidence
Confirmation
Illusion of control
b)
Heuristics:
Representation
l/n equal weight
Availability – overweight recent
Anchoring – overweight initial
c)
Framing – reference points
d)
Manifestations:
Winners curse – You paid too much
Gamblers fallacy – Law of small numbers
Sunk cost – regret avoidance (Prospect theory), Reputation loss
Valuation – Single workable scenario vs range
Implications:
Investors irrational
Shield managers
Managers irrational
Limit discretion
Arbitrage – law of one price – equal rate of return principle
Separation Principles/Decision Rules
1.
2.
Market Value Rule: Maximize shareholder wealth. Separating ownership from management raises
conflict issues. Control mechanisms:
a)
Management incentive compensation contract provisions
b)
Management ownership interest
c)
Management labor market (Reputation)
d)
Market for corporate control
e)
Internal control mechanisms (Board of Directors)
NPV Rule - choose projects whose returns exceed their cost of capital (r ≥ c*). Need to consider
multiple risk adjusted discount rates and option value of strategic investments. Discount rate is a
function of the risk class. Note problems re: optionality.
2
FINANCE NOTES
D.
3.
Dividend Irrelevance (except for agency cost, signaling and option pricing issues)
4.
Capital Structure Irrelevance (except for taxes, agency costs, signaling and option pricing issues)
Statistics: beware data mining, which is prevalent in non experimental sciences lacking controlled
experiments
1.
Reliance on past as (prolog vs history)
2.
Descriptive vs predictive
3.
Issues – normality, survivorship, stationary, independence, sample size
4.
Movements – go beyond mean and variance to skew and tails
5.
Beyond the data – out of sample issues
6.
Correlations – state dependent and lack integrating model covering both default and spread widing
7.
VAR – best of worst. Need expected shortfall analysis to get into tail
8.
Mean reversion
9.
Goodhart’s law – sociological uncertainty principle – when a measure becomes a target it cease to be
a good measure (behaviour change)
10.
Gamblers ruin – sufficient capital to withstand rare event
Note: Structured Finance Meltdown
E.
Decisions as risk (DAR)
CONTROL
monitoring
DAR
incentives
Agency
problem
II.
Asymmetric
information
control
Bias
VALUATION: COMPETING MODELS OF THE FIRM: ACCOUNTING VS.
ECONOMIC. CONVERTING PERFORMANCE ESTIMATES INTO PRICE
ESTIMATES.
A.
Capital Markets
1.
Role - opportunity cost background
Efficient Frontier
r
r
CML
WACC
RF
σ
σ
Risk of Firms Existing Assets
3
FINANCE NOTES
2.
Risk and Return: mkt prices risk proportionate to covariance with aggregate risk.
a)
Portfolio Theory - Portfolio risk is not the weighted average of individual variances. Covariances give rise to risk reduction through diversification. (Impacts denominator but not
numerator; θ Ε(v) discounted at lower rate is still zero) - Remember, in a crisis, all correlations
go to one (Hurricane example).
b)
Distinguish - Systematic from unsystematic risk.
(hedge)
(diversify)
note: systematic risk is the only risk form compensated because diversified investors willing to pay a
higher price. Note – consider 3rd/4th movements – skew/tail (tail risk created by feedback loops)
3.
Interest Rates
a)
Determination - i = r + E (∆P) + IRP (inflation rate risk premium)
b)
Term Structure - yield compared to maturity/credit curve
i
BBB
A
AA
4.
t
Price Setting Process: cash flow, risk, timing
a)
Basis - risk and return i.e. share value based on expected cash return discounted at risk
adjusted rate.
b)
Efficiency - market quickly reflects available information. Based on competition that quickly
eliminates systematic deviations. (Note: Chaos mechanism: fundamental + technical factors)
c)
Technical factors – can overwhelm fundamentals in short term
d) Complex adaptative systems – complex (nonlinear) with tight coupling
(amplication)
5.
Behavioral
Asset Pricing Models
a)
CAPM - r = r + B (Rm - Rf)
f
Units of risk
b)
Price per unit of risk
APM - r = A + B I + B I + ... B I + E +
j
j 1t
2j 2
nj nt
jt
- factors - term structure (Bonds-Bills), ∆GNP (Survey), and default premium (Bds - Gov)
F/F - r = f (1/Size, B/M, Momentum)  Returns = F (market, HML, SMB, WML)
Fed Model: E/P – T
Key elements: luck, skill information, risk
B.
Accounting Model of the Firm: Convert from accrual to cash basis, and from cost to market value (i.e.
mark to market). Balance sheets are a scorecard for money spent and not value.
P/E = (1+ g)/(K -g) ⇒ 1/K when g=0 } M/B = P/E x ROE
e
e
M/B= (ROE-g)/(Ke-g) ⇒ ROE/K when g=0 }
e
4
FINANCE NOTES
MTM B/S - RHS @ Public
MTM B/S - LHS @ Private
NWC
Debt
FA
Equity
PVGO
C.
Economic Model of the Firm: Firms compete in two markets, product markets for customers and financial
markets for capital. They trade at two difference prices within financial markets, a lower passive intrinsic
value and a higher control price.
1.
Valuation Overview - V = MAX (liquidation, Going Concern, Third Party Sale) - method used
depends on point of life cycle and market conditions - value of asset with no cash flow is only what
someone will pay you for it [Sardine theorem]
Timing
Mkt
Size
Independent
value
TPS – Startup
GC – Mature
Buyer
driven
value
Liq – Decline
V=f (horizon)
S/T – voting
L/T – Weighing
V = CF
r–g
i
2.
Emerging
High mature
growth
Mkt
Stage
risk
Discounted Cash Flow/Going Concern
a)
Traditional Adjusted Cost of Capital (ACC/WACC): use after tax WACC and adjust for
interest tax benefit in cash flow to that of an all equity financed firm. Developed for situations
involving a constant capital structure. (measure asset cash flows independent of how financed)
V
EN
=V +V
S
V = V + NOC - V
S
O
V = Max (0,V – x)
D
S
D
V = Min (V, X)
D
V =(NOPAT/WACC)+[I(ROA-WACC)T÷WACC(1+WACC)]
O
(assets in place)

(growth)
FCF1
FCF2
Re sidualFCF

 ...
; PE focus on takeouts
(1  WACC ) (1  WACC ) 2
(1  WACC ) n
(Forecast Period)
> transaction X
(Residual / TV)
5
FINANCE NOTES
Inputs: sales growth, operating profit margin, working capital rate, CAPEX rate, tax rate, and
WACC
NOPAT=EBIT (1-τ) = NI + Int (1- τ) = EBIAT - (Int (τ))≈EBIAT if use τ
s
FCF=NOPAT-WCI+DEP-I=EBDITA - (τ+WCI+CAPEX+Int(τ))
WACC=[K (1-τ)XD/D+E]+[KexE/D+E]
d
Weights: market or forward targets
Note: leveraged firms ⇒ ∆ D/Cap use target D/Cap to avoid understating WACC
assume return to BBB ≈ 50%D/Cap
Application: limited to assets in the same risk class as the firm
note: equity risk premium as a duration measure/ DF= DA - DL
= DA – (DD + DE)
- expands during bear mkt.
- contracts during bull mkt.
Bu  BL  (1  [(1   ) D / Eo ])
BL  Bux (1  [(1   ) D / En ])
 (1  (1   )( D / E ) n ) 
BLn  BLo  

 (1  (1   )( D / E ) o ) 
2
Adjust – B – use industry average to offset low individual R (Bloomberg, VL, …)
Downside Beta
Forecast Period: period in which ROA>WACC; REFLECT ENTIRE CYCLE; MEAN
REVERSION
note: length should not affect value; merely allocation
Residual: normalize with cyclical firms
Startups: Market Size x Share = Revenues; then apply OPM convergence:
RV=NOPAT ÷WACC
n
other: book value, capitalization, liquidation
NOC: non-operating capital e.g. securities, unconsolidated sub
Country Risk Premium = default spread x [σ stocks / σ gov]
b)
Compressed: use adjusted unleveraged pretax discount rate Re and after tax cash
u
flows. Best for leveraged firm with rapidly changing capital structures as the debt is
repaid.
FCF=NI+D+A+∆DT+Int-(CAPEX+WCI)
=EBITDA+∆DT-(CAPEX+WCI+TP)
TP=(EBITA-I)xτ
V=NI+D+A+∆DT+Int-(CAPEX+WCI)÷[Rf+7.0)-g)]
6
FINANCE NOTES
=EBITDA+∆DT-(CAPEX-WCI+TP)÷[Rf+7.0)-g)]
note:
A
limitations on use of DCF - merely a proxy for market value based on current use of
assets and strategy; does not reflect takeover premium and alternative higher value
added strategies
B
reality check: confirmation of value range by all three techniques and calibration
(beware 1/n heuristic)
V
Economic Value
Financial Value
c)
t
EVA = (ROA - WACC) x BC - backward looking vs DCF forward looking
d)
EVA
 Capital
WACC
APV:
V
FCF1
(1  reu )
1
3.

FCFs
(1  reu )
2
 ...
FCFn (1  g ) /(reu  g )
(1  rEU ) n
 TS  APVu  (1  L)
Option Pricing (ROV): DCF applicable for traditional firms with cash cow
characteristics (i.e. relatively predictable cash flows). Firms with high risk
characteristics from either financial difficulty or growth firms have unpredictable cash
flows that are difficult to evaluate using DCF methodology. These situations are better
valued using option pricing.
a)
Call Option Valuation
C = F(S,SD,X,T,Rf,D); C ≥ max (0,S - X
-rt
e
-rt
- De )
C = disE((S)S>X) x Prob(S>X) - dis X ⋅ Prob (S>X)
C = SN (D1) – K
RfT
N (D2)
 SN ( D1)  K e RfT N ( X   T )
Hedge ratio Discounted
Probability
strike
option exercised
P (S>k)
D1 - Hedge ratio - ∆O /∆ - approaches 1 when option is in the money
P
P
D2 - Probability that option will finish in the money (i.e. S>X)
Note: implies probability of default
Intrinsic value - value of right to buy at exercise price (i.e. S-X). Time value possibility of achieving value at a later date; equal to premium minus intrinsic
value (P - (S-X)).
Put / call parity: S  P  C  x /(1  R f ) t
7
FINANCE NOTES
1
b)
c)
2
3
Covenants: F(S, [σ] , [D] , R , [T,X] )
f
(1)
Asset Sub
(2)
Dividend Payout
(3)
Payment Priority
Issues: distinguish options from opportunities
(1)
Scope Options: enter new markets in business
(2)
Timing Options: reacting to new information
High NPV ⇒low time option value
4.
Market Value Approach - break-up analysis; even though assets generate sufficient
returns, the assets may be worth more to others. Business Model Issue.
a)
fit test - assets are worth more to someone else
b)
focus test - negative synergies from dissimilar operations, reduces value
(management as an off balance sheet liability)
III
PERFORMANCE: TRANSLATES VALUE INTO PRICE
A.
Strategic Framework: Firm policies + industry structure = financial results.
Notes: golden triangle – growth, profitability and liquidity
1.
Levels - Corporate: Where to compete? (BCG - firm as internal capital market)
Business Unit: How to compete?
2.
Questions:
Where are we now?
Where do we want to go?
How will we get there?
3.
Process
a)
Industry attractiveness - identify threats and opportunities
(1)
Forces - buyers, suppliers, entrants, substitutes, and competitors.
(2)
Competitive rivalry - demand growth, fixed cost intensity, exit barriers, product
differentiation, switching costs, and market shares.
(3)
focus - risk of commodity pricing; stage in life cycle; stability.
b)
Competitive position - strengths and weaknesses along value chain. Issue of whether firm’s position
is dominant, strong, viable, weak or nonviable.
c)
Competitive advantage - means chosen to gain a meaningful competitive position.
(1)
Options - cost leadership or differentiation.
(2)
Scope - across industry or within niche.
(3)
Tests - sustainable, comparative, active
8
FINANCE NOTES
B.
Market to Book Model M/B ≈ r/c* ≈ ROE/Ke = P/E x ROE
Note: distortions re: intangible assets and expensing investments
Per 
1 ROE  Ke
g


Ke ROExKe Ke  g
F ranchise
factor
1.
PEG  PER  ( g  DY )
growth
Shareholder value:
TAX
OPM
Return { 
ATO
LEV
EBIT S
A
  (1   )   (1  Payout)
S
A
E
DPR
FCF
–
Growth
Real Ind.
Strength
(Market)
+
Winners
Y
>1
Z
1MV/BV
Losers-X
liquid
LBO
X
<1
+
ROE-Ke
(Position)
Omega curve
Profitability (π)
π
Mass market
Low cost
unique
high
Above
Averg.
Steady
Innovation
Niche
Average
high entry cost
Low
me too
Small
Medium
Large
Market size
Note: Returns = F (industry growth, HHI)
HHI ≥ 4000  concentrated
≤ 2000  fragmented
9
FINANCE NOTES
Business Strategy / Life-cycle framework
Industry
Structure
+
Competitive
Position
Strategic choices
• Target market
• Product
• Place
• Promotion
• Price
Core
Competencies
Maneuver x Payoff = Strategic Leverage
Business Plan and Resource
Allocation
Threat of new
entrants
Bargaining power
of suppliers
Rivalry among
existing firms
Operational skills
• Business processes
• Feedback
• Knowledge creation
Bargaining power
of buyers
Threat of
substitutes
Increasing CFROIs &
High Reinvestment
Above-average but
fading CFROIs
Average
CFROIs
Below-Average
CFROIs
High innovation
Fading CRFOIs
Mature
Restructuring
needed
FADE
CRFOIs
Reinvestment
rates
Discount rate
(investors’ required
rate of return)
Source: CSFB HOLT, drawing on Michael E. Porter, Competitive Strategy; Milind
M. Lele, Creating Strategic Leverage; and Bartley J. Madden, CFROI ® Valuation
C.
Growth -focus on the quality of growth (i.e. ROA, σ) - consequence not goal of value max behavior.
1.
Options - related or diversification
2.
Mode - Internal or external
3.
Sustainable Growth - internally sustainable with fixed capital structure and dividend policies
g* = ROE (1 – Payout)
4.
D.
Agency Conflict - pay is strongly tied to size. Encouraged in mature firms because sustainable
growth capacity exceeds available positive NPV investment opportunities.
Expectations – You create value by beating expectations vs an objective hurdle. It is hard to beat
expectations. Use to set strategy:
ROIC - WACC
+
–
Grow
Harvest
Transform
Exit
Hi
Likelihood of
exceeding
expectation
Low
E.
Reverse Engineering – use to uncover expectations value gap:
1.
Value management plan
2.
Value analysts forecasts
3.
Value implied value drivers in stock price
10
FINANCE NOTES
4.
IV.
Resolve discrepancies between 1 and 2, and 1 and 3
CAPITAL STRUCTURE
A.
Overview: Value impact of financial policy is dependent on taxes, (distress) transaction costs, investment
policy impact, and signaling.
1.
2.
Areas
a)
capital structure: tax, agency, investment policy regulations (e.g Finco) and signalling
b)
return of funds to shareholders: agency and signaling
c)
financial instruments: signaling, tax and distress.
Signaling - signaling future cash flow through financial policy
a)
model: sources = uses
Operating cash flow + new securities = investments + dividends / repurchases + debt service
Operating cash flow = investments + dividends + repurchases - new securities + debt service
b)
implication:
Outflows signal higher expected future cash flows; whereas inflows signal lower expected
future cash flows
Note: debt-neutral-pay it back
Structure - Claim on assets and income; control
B.
Debt Policy - the appropriate level of debt in the capital structure given the interest tax shield valuation
impact (TD). Value of debt flows from tax deductibility of interest and not from leveraged EPS or ROE
which is offset by increased cost of equity and decreased price/earnings ratio.
1.
Issues
a)
b)
Benefits
(1)
Tax benefit: estimated at 20% of nominal TD value; impact of debt related tax shield
(2)
Nontax benefits: operating benefits, reduced reinvestment risk and option pricing.
Financial Distress - Offsetting the explicit tax cost advantage of debt is the implicit
opportunity cost disadvantage from financial distress (transaction/agency costs)
(1)
Bankruptcy Costs - 3-5% (TA)
(2)
Financing constraint: interrupt ability to fund investment plan in difficult markets.
Over levered
Under Bankruptcy threat
YES
Debt equity swaps
Sell assets
Renegotiate
NO
Use earnings to repay
Eliminate dividends
Issue new equity and retire debt
Extend maturities
11
FINANCE NOTES
.
PV of financial distress
V
Agency Costs
r
Pv of tax
shield
D
T
RF
E
Distress
D/E
d/e*
D/E
Bkrpt when V<X (Balance sheet test vs liquidity test – inability to pay bills as
scheduled)
Distress Cost
Probability – quality spread
Magnitude – MTM B/S re-intangible value
Shape of Curve = F (economy, asset type, EBIT)
V
Aircraft
Real Estate
Reflects ability to realize
value independent of firm
which owns asset
Software
D/V
c)


D  1 
D
1

  1;  1 
D
E 1  D 
C
1
 C 
E
Theories






2.
Capital structure strategy mkt access conditions
Strategic Tradeoff
Pecking Order
Issue securities with lowest asymmetry costs first to min discount
Free Cash Flow - MDC
Dynamic - lever up/paydown
Factors Affecting Debt Policy D/E = f (T,1/business risk, tangible assets/total assets,
liquidity, age, size, 1/market share)
a)
Effective Marginal Tax Rate - influenced by level and stability of taxable income.
Interest tax shields are less valuable to loss or tax exempt firms.
b)
Risk Level - balance business and financial risk consistent with a total risk level.
(1)
Business Risk - variability of NOPAT income stream is influenced by sales
variability and operating leverage.
12
FINANCE NOTES
(2)
Financial Risk - variability of NI due to increasing debt service. ∆Capital
Structure impact WACC
↑D/E ⇒↑Ke but ↓ WACC as increase % of lower cost debt
Total Lev
Δ Sales
Δ EBIT
Op Lev
Δ NI
Fin Lev
c)
Asset Type - tangible assets afford lenders asset protection. They are independent of
the firm as a going concern for realization. Therefore, they support increased leverage.
(i.e. tangible assets have lower distress costs; lower LIED)
d)
Firm’s Life Cycle - Interrelationship between financing and investment decisions;
distress costs as an inverse function of firm age.
e)
(1)
Start-up - low taxable income, high business risk and the need for flexibility
without covenant restriction (opportunity costs of foregone investment exceeds
tax savings) necessitates low leverage.
(2)
Growth - begin to add debt. Still, low taxable income, high risk and need for
flexibility favors low leverage. (r ≥ c* on both new and existing investments.)
Strategic Capital Structure Theory - mkt leaders have lower D/E to enforce price
discipline
(3)
Maturity - high NPV investment opportunities become scarce, taxable income
increases, business risk decreases and leverage should increase. (r/c* ≥ 1 for
existing assets, but r/c* ≤ 1 on new investments.)
(4)
Decline - favors leverage and distributing proceeds to shareholders (value
transfer). (r/c* ≤ 1 for both existing assets and new investments)
Liquidity - As debt levels increase, need increased level of liquidity to provide a
cushion against cyclicality and markets closing e.g. HYB. Note: D/E = F(liquidity);
Execution risk realised price < expected
Factors – mkt depth
– position size
NLR  RCA  CMS
;
DS  CPLTD  I
> 1.5x alternatively RC =: 10-15% sales or 1-1.5 x EBITDA
LI 
13
FINANCE NOTES
EBITDA
Price
Offer
PO
Bid
Crisis
Exogenous – mkt characteristics
size, bid/offer spread, depth
Endogenous – position size
T/Posit
Impact of liquidity on Asset Prices (e.g. LTCM)
BKS: Arbitrage higher return illiquid assets (loans) with lower return liquid claims
(deposits)
RCA  [(INV  AR  REC  AR) - STD]
CASH BALANCE
; Assumes negative EBITDA
EBITDA
Conclusions - borrow independent of need and against debt capacity. Use funds for
investment, dividends, repurchases, acquisitions, or marketable securities. Beware Telecom
e.g., just because bubble drives down WACC/don’t borrow and over invest in suboptimal
projects.
Cash Burnrate 
3.
Approach: Marco (peers/ratings); micro (overlay projections).
a)
Measuring Debt Capacity
B/S < Ratios, Peers, Rating)
CF < CDCF, MDC
Market: KMV
AR < ABL, BV
(1)
Comparative ratio analysis
(2)
Bond rating objective - (S&P ratio/rating guideline)
Note:
+ fcf ⇒ lower rating needed and higher D/CAP
- fcf ⇒ higher rating needed and lower D/CAP
(3)
Maximum debt capacity - assumes a temporary abnormal maximum debt
level. Calculation:

EBITDA  (T  CAPEX  WCI )
 1 
 AS   EBIT   t    AS
 1
 n 

i  
n


= f (operations, amortization, cash interest, asset sales, refinance)
MD 
externally driven
Note: Structuring (commercial vs financial firms)
R/C: 10-15% sales, 1-1.5xEBITDA
14
FINANCE NOTES
T/L: 3-4x EBITDA
A=Amortizable in 5-7 years
B=SDX - T/L A
T/D: 4-5x EBITDA
Second lien
Sub: TD - SDx
Equity: Need - TDX
(4)
Asset based - Evergreen revolver with liquidation value advance against assets
(5)
Business value – advance against mv of business
Notes: Refinancing risk mitigated by interest & asset coverages and mkt access
measured by rating
b)
Rate - depends on rating and term
Note: Target Int Exp = EBIT ÷ FCC
T
FCC ⇒ Rating target
T
Targeted Debt = TIE ÷ R = (EBIT/FCC) ÷ R
R ⇒ R + QRS
F
QRS ⇒ Rating
c)
Capital Cushion Required: E(L) = ADR x (1-RR) x AL x AU x RM; σ(E(L))
Note: IDR = CS ÷ (1-RR)
d)
Credit Ratios
Default: FOCF/P+I
Default Loss: D/CAP
Liquidity: P + I – (Cash + MS + RCA) = Net liq.
C.
Liability Management - involves not only determining the aggregate level of debt, but also the type of debt,
not limited to cash markets; consider derivatives, (e.g. sale of put options as share repurchase alternative)
and insurance
1.
Overview
a)
Maturity: long or short
b)
Interest rate risk: fixed or floating.
c)
Currency risk: USD or Fx
d)
Covenants - D/E, FCC, NW – (early amortiz: trigger a liquidity crisis before firm becomes
insolvent)
e)
Deferred or current pay
f)
Senior/subordinated: value of seniority: O/C payment priority / first loss.
15
FINANCE NOTES
g)
Tax status of investor or issuer - debt vs. preferred stock
h)
Call feature
i)
Straight or convertible
Structuring Box
Tax
Accounting
Bus. Plan
Regulatory
Fin. Char.
Deal Inst.
Fin. Plan
Mkt. Cond.
Legal
j)
Accounting: on or off B/S
k)
Credit support
l)
Security
m)
Amortization - Straight; balloon; staggered; bullet (duration)
n)
Public vs. Private


o)
D.
Competitive
Focus on balance between cost and flexibility (i.e. ability to raise capital at an
acceptable cost under a variety of conditions).
Liquidity - ease at which a firm can convert assets into cash without value loss. (Bid Offer Spread) . Alternatively, ability to borrow.
Refunding BER = coupon $/call price
Financial Instruments - Design of instruments is a marketing problem concerning the packaging of claims
against real assets which exploits capital market inefficiencies such as, an unserved market niche, taxes,
regulation, and mgmt incentives.
1.
Overview - revolution in development due to increased market volatility, deregulation, and
technology. Basic components are equity, risk free bonds, puts and calls.
a)
Scope: high yield bonds, securitization, futures and options, and risk management.
CA
LT
D
E
T
BK
=
Growth
b)
Focus – both collateral and structure
16
FINANCE NOTES
2.
Instruments - focus on: claim on income and assets and right to participate in decisions.
a)
Preferred Stock - Preferred may be advantageous given the (inter corporate) 70% dividend
exclusion. Used by non-taxpaying issuers who would be unable to use debt-related interest tax
shields. (Note: ARPS - exchangeable into debt once firms become taxable.)
b)
High Yield Bonds (credit + call risk)
(1)
Covered Call - buying common stock and writing a call. If the stock fails to appreciate
you receive the call premium. If the stock appreciates, the call is exercised through a
retirement.
(2)
Form of senior equity - intermediate position in pecking order. Allows full utilization
of debt capacity and avoids equity issuance. (Reverse convertible).
c)
Original Issue Discount/Zero Coupon Debt - significant tax advantages from the tax
deductibility of discount (NOTE: Tax Reform Corrections, Tax Limits).
d)
Income Bond - tax benefit of debt without decreased flexibility from mandatory debt service
e.g. PIK; DIB; Splits, Indexed.
e)
Dual Currency - pay interest in one currency and redeem principal in another. Firm swaps
only its interest payments. Implicit currency option contained in dual currency bonds.
f)
Yield Curve Notes - Long-term note with shorter term resetting of rates.
g)
ESOP - Similar to qualified plan; consider dilution, control and repurchase obligations. Tax
advantages - largely illusory. Deductibility of principal and interest - confusing operating
expense with a financial flow. Tax deduction arises from compensation expense, not from
interest or principal payment.
h)
Equity Linked Debt
i)
(1)
Exchangeable Debt - debt convertible into the common stock of another firm.
Difference between market price of third party stock and exchange price is tax
deductible. Used to dispose of minority interests.
(2)
Warrant - call option issued by firm (conventional options are written by third parties).
Exercise of warrant increases firm’s capital; tax advantage of warrants: value treated as
a deductible discount. Recaptured, however, if warrants are not exercised.
(3)
Zero Coupon Convertible <Lynon>
Convertibles - equivalent to straight debt with a nondetachable warrant (with an acceleration
right in bankruptcy).
(1)
Usual Pricing - 6-8% coupon, 2-4 year break-even with a 20-25% premium (breakeven
= conversion premium % ÷ (debt rate - dividend yield).
(2)
Stated Reasons
(a)
Less Expensive than Straight Debt - focus on accounting costs and ignores the
option cost (out-of-the-money option).
(b)
Raising Equity at a Premium to Current Price - proper comparison is not current
stock price to conversion price, but with conversion price to market price when
conversion occurs. Also, no guaranty that conversion will occur. Finally, firm
17
FINANCE NOTES
could achieve the same result by issuing straight debt now and refunding with
equity later.
(3)
(4)
Use
(a)
Impact - drop in stock price usually follows announcement. May be due to
normal drop when an equity issue is announced.
(b)
Considerations
(i)
cheaper form of equity issuance
(ii)
control agency costs - consistent with pecking order theory.
(a)
relatively insensitive to issuer risk. Thus it reduces agency
conflict between shareholders and bondholders for smaller and
more risky firms where intangible growth value is difficult to
measure.
(b)
limitations - primarily limited to smaller, more risky growth firms,
and should not be used by large mature firms.
Calling Convertibles
(a)
Call policy - Call convertibles whenever conversion value reaches call
redemption price to minimize income to bondholders and to eliminate their
option protection. (Conversion value = Conversion ratio x Current share price.)
Note: Voluntary conversion when dividend rate exceeds interest yield or when
the stock value exceeds the bond value.
(b)
k)
(i)
Viewed as a negative signal.
(ii)
Reduced tax shield.
(iii)
Reward sleeping investors.
PERCS



E.
Costs of calling a bond:
Preferred stock that converts into equity: used by firms considering cut in dividend/less
negative signal
Sell priced at C/S; limit upside in exchange for higher dividend ⇒ signal
Callable at Prem which offsets lower dividend
Equity Management - involves three main topics: new share issuance, dividend policy, and stock
repurchases.
1.
New Share Issuance
a)
b)
Issues
(1)
pricing - are the shares fairly priced?
(2)
use of proceeds - earnings dilution unless new funds earn appropriate rate.
(3)
control
Problem Areas
18
FINANCE NOTES
(1)
(2)
Cheap Funds Fallacy - looking at the nominal or marginal cost of capital.
(a)
Marginal Cost - ignores the instrument’s impact on the capital structure. Equity
in the capital structure supports debt. Need to allocate portion of the implicit
equity cost used to support the new debt.
(b)
Nominal Cost - using E/P or D/P as surrogate Ke. New shares have same claim
on earnings and assets. Earnings must be created with the new capital to prevent
the stock price from falling. The return required on the new equity is Ke.
Agency Problem - concerns information asymmetry.
(a)
Argument - Management will issue common stock when overvalued based on
inside information.
(b)
Impact - offering dilution: outstanding stock price drops on average by 3% upon
announcement of an equity issue (equal to 30% of new issue). Corporate wealth
increases at shareholders expense.
Note: Pecking Order Theory: issue securities with the smallest asymmetry first
(i.e. instruments that are less dependent on the value of the firm as a going
concern - contractual vs. residual claims). Focus on internal funds, then debt,
high yield, convertibles, preferred, PIK/DIB, and finally equity.
Note: underwriting costs: spread 3-6%, underpricing
2.
Dividends
a)
Arguments
(1)
MM - provided investment and financing policies are fixed then dividends do not affect
value.
(2)
Why Dividends Matter
(a)
Information - corporate reluctance to reduce dividends implies that dividend
increases are sustainable, and based upon positive long-term earnings forecast
by management. (signaling)
(b)
Agency Cost - reinvestment risk is lowered by reducing the assets under
management control.
(c)
Option Pricing - dividends increase financial risk by reducing creditor’s asset
cushion.
b) Factors: growth, leverage, taxes, maturity
3.
Stock Repurchases - alternative form of shareholder distribution. Need to distinguish between
repurchases based on excess corporate funds (a dividend substitute) from debt financed repurchase (a
capital structure decision); Wealth transfer issue between tendering and nontendering shareholders.
a)
Reasons:
(1)
Investment - N/A ie. produces no cash flows
(2)
Capital Structure Change - same change is possible through debt financed extra
dividend. Benefit based on interest tax shield.
19
FINANCE NOTES
b)
(3)
Manage ROE - EPS - same result through extra dividend and reverse split. Smaller
and more risky firm.
(4)
General Corporate Purpose - no reason (except dilution) why newly issued shares
should not be used.
(5)
Reduce Dividends - can do without a repurchase. Also, saving in the future what you
payout today. Thus, no real gain.
(6)
Tax Based Dividend Alternative - Favorable capital gains treatment.
Signaling Impact: Use to reduce an expectation value gap. Set price at mgmt.’s value
estimate; amount repurchased tied to max debt capacity.
Form
Open MKT: best for excess cash dividend type distribution
Fixed price T/O: 12% valuation ∆
Dutch Auction: 8% valuation ∆. Management specifies the number of shares it will purchase
within a specific range; lowest price necessary to retire all shares sought then becomes offered
price. Reverse of a normal auction (i.e. instead of bidding price up - bid price down).
c)
Note: Cash Distribution Alternatives
Distribute
Cash Flow
Committing to distribute
future cash flows through
contractual obligations
(i.e. raise debt)
Distribute
Existing Cash
Increase
dividend payout
Open-market
share repurchase
Premium selftender-offer
share repurchase
Leveraged recap
Leveraged
Buyout
Degree of Cash Distribution
Low
F.
Implied change in Capital Structure
High
Securities Issuance
1.
Underwriting Services
a)
Security pricing certification - underwriter certifies that the issue price is fair based on due
diligence.
b)
Marketing/distribution - placing power
c)
Risk transfer/insurance
(1)
Risks
(a)
Waiting/market risk
20
FINANCE NOTES
(2)
2.
(b)
Pricing Risk (e.g. Lyondell offering)
(c)
Marketing risk. (e.g. unable to place)
Committed underwritings as a put option - with spread (premium), exercise price
(proceeds to firm) and exercise price plus premium (price to public)
Techniques
a)
Traditional Underwriting
(1)
negotiated vs. competitive - in a negotiated offer, the issuer has less control over the
terms and timing of the offer. Thus, investors have fewer worries that the issue will be
structured to exploit their information disadvantage.
Note: negotiated offer, higher fees, delay/shift price risk to issuer.
b)
(2)
best efforts vs. firm commitment - best efforts acts as a red flag. (e.g. Time Warner)
(3)
stabilization and the green shoe option - green shoe option allows underwriters to
purchase additional stock on the same terms as original offering. Provides underwriter
with a cushion against covering any short provisions incurred by syndicate (adds 1/2 to
1.5% to cost).
415 - competitive underwriting, reduced costs for large frequent issuers with at least a BBB
rating. 415 reduces waiting risk and constitutes a rational response to increased market
volatility.
Note: not used re: equity - need price certif.
c)
Rights Offering - option allowing shareholders to purchase shares directly from firm at below
market price to maintain pro rata ownership. Involves a repackaging of stock value between
value of the right and the ex-right share price. Rights offering benefits:
(1)
Reduced Flotation Costs - save underwriting spread.
Note: underwriting cost = Fee + underpricing
(2)
d)
Minimize Wealth Transfer - Rights offering minimize wealth transfer between
existing and new shareholders. Yet:
(a)
there is no underwriter price certification - unless it is underwritten.
(b)
shareholder sale of rights serves as a bad signal.
(c)
risk of not receiving funds (unless underwritten).
Private Placement - advantage of being flexible, quicker, lower transaction costs, and less
size sensitive. Offset by covenant, rate, prepayment penalties and maturity disadvantages.
Increased junk bond competition may be offset by rule 144(a) creating a secondary trading
market.
Note: NAIC - ratings arbitrage
Note: 144A vs. Public, spread ≤ 3BP
21
FINANCE NOTES
V.
FUNDAMENTAL CORPORATE CHANGES
A.
Mergers & Acquisitions: beware of bubbles (temporary separation of price from value based on belief that
historical price movements will continue). Technical swamp fundamentals/momentum. M&A as a tactic vs
strategy
1.
Considerations: strategy, finance (price, value and funding) and execution (tactics and integration)
a)
Types - horizontal, vertical, conglomerate and turnaround.
b)
Valuation Methods - Cost, market, and income. Distinguish cost from value. Focus on value
creation through arbitrage possibilities between equity and underlying asset values. Easier to
determine price than value. V = MAX (liquid, GC, TPS)
(1)
V
EV
Market - focus on multiples or premiums over trading value. Value of an asset without
cash flow is only what someone will pay for it (TPS)/cyclical adjustment: average firm
margin over the cycle x current sales or average industry margin x current sales
(a)
FV
(b)
t
Capitalization (existing public firms)
(i)
basis - sales, earnings, assets or book value (equity)
(ii)
adjustments - control premium (↑50%) and liquidity (↓ 30%) discount
Comparable Transactions
(2)
Cost/Asset Values - appraisal or liquidation value, replacement cost or book value.
Balance sheets measure money spent and not value.
(3)
Income/Free Cash Flow - V = fcf/c*;
(4)
(a)
ROE Approach - ROE = E/Eq; P = E/ROE and E = P x ROE
(b)
Rule of Thumb – Earnings yield 1.5 - 2 times Rf by second year of operation.
M
R
LBO/MDC Method:
D   Cap  FD
 FD
 

 
Pm  
 EBITDA   1 

 EBITDA 
EBITDA
Cap
D
EBITDA

 



Note:
Target
Market
Financial
Size/Growth
Scarcity
Share
40% equity
Revenue
Earnings
Cash Flow
Growth
Competition
60% debt
Timing
c)
Business
Personal
Talent/Skills
Product/Tech
Distribution
Milestone
Risk Perf.
Investor adj
Customer
Employee
-
Debt %
OPM %
OPM = 15%
Structure - asset or stock sale; triangular (target mergers with subsidiary) or reverse triangular
(subsidiary disappears/merges into target).
O
22
FINANCE NOTES
d)
Accounting - push down accounting (carryover basis) no goodwill/decrease equity; asset
writeups
e)
Payment - cash vs. stock
f)
Taxes - taxable or tax free transaction premium: taxable/cash - 38% vs nontaxable stock 18%
reflects tax difference to selling shareholders.
g)
Defense Mechanisms/Counters
poison pill: condition delivery on close (beware “dead hand”)
dual class: condition delivery of proxy
fair price: make offer to Board vs Shareholders
2.
Framework - Value creation depends on factors with unique commercial significance, created by the
combination that investors could not duplicate by holding the buyer’s and seller’s stocks in their
portfolio. Note: alternatives - J/V, licensing, etc.
a)
b)
Price vs. Value
(1)
Price - Distinguish passive investor trading value from control price allowing buyer to
alter strategy to higher valued use justifying premium.
(2)
Intrinsic Value - present value of cash flows plus financial, tax and off balance sheet
asset values. Usually reflected in prebid price.
Value added - means of closing gap between price and intrinsic value
(1)
synergy - cash flow from combined firms is greater than the sum of the independent
cash flows due to economies of scale (vol) or scope (interrelatedness).
(2)
Option value - acquisition allows firm to participate in valuable growth opportunities.
(3)
Operating Improvements
(a)
(b)
c)
Balance Sheet
(i)
Assets - Change mix, increase turnover or sell off.
(ii)
Liabilities - increase leverage to utilize unused debt capacity or
deleverage over leveraged firm to reduce distress/trans costs.
Income Statement
(i)
Increase Revenues
(ii)
Reduce Costs
Relationships - compare value received with value paid to determine value created.
(1)
Value Received - (Vr) includes stand alone value plus value added factor.
(2)
Value Paid (Vp) = cash + market value of stock + debt assumed + PV from off balance
sheet liabilities (leases, pensions and EPA) + golden parachutes and transaction costs.
(3)
Market Value = stand alone value.
(4)
Value Added Factor = synergy + growth option value and oper. improvements.
(5)
Net Value Added (NVA) - Value added less premium paid.
23
FINANCE NOTES
VR = Stand Alone + Value Added
VP = Act Prebid MV + Premium
NVA = Value Added - Premium
Financial
terms
Note: Value sources
Buyers Max Terms
Bargain purchases
Financial engineering
Private
Seller’s Min
Terms
Operating improvements
Non Financial terms
(6)
(7)
d)
3.
Determining the Discount Rate (a)
Business Risk - Use seller’s business risk i.e. unlevered asset beta
(b)
Financial Risk - Use buyer’s target capital structure to relever beta.
Premium:
(a)
Takeover price
Stupidity
Competitive necessity
Information
Synergy
Lower WACC
(b)
Under valuation
Current price
Foreign M&A: discount local currency flows at local rates; spot back to home FX.
Evidence
a)
Who Benefits - not unlike most competitive endeavors most mergers fail from the acquirer’s
viewpoint (behavioral finance: winners curse). Selling shareholders are primary beneficiaries.
Distinguish, however, friendly from hostile tender offers. Need to focus on total gain, and
whether assets end up in most efficient use, e.g. Campau/Federated
(1)
Tests - ROA>c*, ROE>Ke and buyer’s stock price outperforms peer group
immediately following the acquisition.
(2)
Common mistakes
(a)
Overpay - e.g. B of A /Merrill
(b)
Misjudge industry risk - e.g.Wachovia
(c)
Overestimate synergies – RBS/ABN
(d)
Integration problems – B of A / LaSalle
(e)
Due Diligence – TPG/WaMu
24
FINANCE NOTES
(3)
4.
Common characteristics of successful acquisitions: Involve closely related
businesses; Use of stock vs. borrowed funds - (incentive) - low premiums (avoid
overpaying); Retain management (aids integration); Smaller transaction size (aids
integration)
Hostile Takeovers - struggle by competing management groups over the control of corporate assets.
Companies compete in two markets, i.e. the product market for customers/revenues and in the capital
markets for capital. Market changes require management and strategic adjustments. Management is,
however, reluctant to change once successful strategies due to organizational interia. The delayed
adjustment depresses returns and equity values relative to underlying asset values as management
continues to reinvest in unattractive markets rather than return excess funds to shareholders. The
depressed returns and equity values attract raiders. (profit mitigation e.g. hardware to software)
Note: MV can be less than liquidation value if management refuses to change/liquidate. This creates
an arbitrage opportunity between asset and stock value. (e.g. Europe)
Note: overcapacity: ordinarily: ↑CAPEX →↑ V, but for industries suffering from overcapacity ↓
CAPEX →↑ V
FMV
Going concern value
Liquidation value
DCFV
a)
Benefit: capital market policing mechanism that controls management agency costs, and acts
as an externally imposed restructuring. Part of Schumpeterian creative destruction (economic
Darwinism) that revitalizes capitalistic systems.
Note: 30-50% premium requires gross discrepancy before mkt correction occurs but less
severe than waiting for product mkt failure.
↓ Citi equity > HYB losses
b)
c)
Considerations: costs of large, diversified entities may outweigh benefits of scale and
synergy. This is reflected in conglomerate discounts reflecting management as an off balance
sheet liability. Note: negative synergy
(1)
Overhead: overhead to asset ratio of industrial firms is 2% vs. 0.7% at a mutual fund.
Do industrial managers add three times as much value?
(2)
Complexity (focus test): firms managing single or related businesses outperform those
managing several unrelated businesses may reflect diseconomies of scale.
Takeover risk:
(1)
Institutional barriers/protection


(2)
Decline over time
No defense to a fully priced/financed bid
Economic indicators


ROE – Ke < 0
Dividends/FOCF < 50% (Cash is building)
25
FINANCE NOTES
Cash + Marketable Securities/Market Value > 5%
Debt/Cap < 20% (Under leveraged)
Relative lagging stock price performance

STP > MV
Map
Market Growth
(3)



+
Growth
Neg FCF
Winners
± FCF
0
–
>1
MV/BV
Losers
± FCF
LBO
Pos FCF
<1
ROE – Ke
Market Position
B.
Restructuring - Triggered by product market overcapacity.
Note: Periodic/as needed vs. on-going value planning
1.
Overview - Restructuring involves reallocating assets caused by changes in the economic
environment rendering old management strategies and asset combinations obsolete. <overcapacity>
e.g. retailers Walmart
a)
b)
Forces: deregulation, globalized competition, changing technology, and deflation have
changed the competitive environment. This necessitates changes in strategy and structure to
better adapt to the new conditions. Industries affected:
(1)
Older industries with declining demand
(2)
Commodity industries relying on inflation
(3)
Growth industries impacted by foreign competition
(4)
Industries suffering from poor management/inadequate returns
(5)
Deregulated industries
(6)
Change from national to regional market
(7)
E-commerce impact
(8)
Hedge funds
Symptoms - ROE ≤ Ke and MV ≤ BV or BUV; value gap:
(1)
Expectations gap: stock price less DCF value based on management forecast. Note:
may not need to correct expectation value gap - mkt will eventually get it unless - T/O
or need to raise capital
(2)
Strategy gap: forecast value from current strategy less alternative use/strategy i.e.
takeover value
Note: strategy gap = T/O value - Mgmt forecast
26
FINANCE NOTES
Expectation Gap = Value Based on Mgmt Forecast-current price
c)
Reaction - Restructure operations and financial strategy to fit changed/reduced market
opportunities. Implied market and firm life cycle:
d)
Value Impact - Indirect operating efficiency benefits flowing from financial restructuring are
the major source of increased value. Based on interdependency between financing and
operating decisions. Value motives include:





Tax reduction
Fit/Focus
Improved incentives/concentrate equity
Improved transfer prices/eliminate cross subsidies/reduce reinvestment risk
Increase leverage
e)
Reinvestment Risk - cannot assume excess cash flow will be profitably reinvested or returned
to shareholders. Risk of value destroying investments i.e. FCF invested where WACC > ROA
whenever ability to invest exceeds opportunity to invest.
f)
Managing for Value Perspective
More value with your or
someone else?
LHS
(Cash Flow)
RHS
(Claims)
Management of assets
or liabilities
Better owned by you or
someone else?
•
•
•
2.
Unchanged
Combined with new
assets
– Internal Investment
– Acquisition
– Increasing revenues
More efficient operation
– Decreasing costs
– Tax planning
•
•
•
•
•
•
•
Divestiture
Spin-off
Equity carve out
Being acquired – sell off
Liquidation
– Total
– Large dividend
Leasing
Securitisation
Better owed by you or
someone else?
•
•
•
•
•
Financing mix (debt,
equity, preferred, etc)
Swap or recapitalisation
Maturity structure of
debt
new debt or preferred
issuance
New equity issue
•
•
•
Subsidiary debt
debt refunding,
defeasance
Share repurchase
– Tender
– Open market
Forms
a)
Asset Restructuring - involve ownership or management changes:
(1)
Divestment - asset or division sale, best used when seller is able to obtain a premium
from a natural buyer with whom the assets are a better fit.
(a)
Basis - asset redemption to improve returns. Means of transferring assets to
higher value use. Based on buyer’s ability to operate assets more efficiently
(based on comparative advantages).
(b)
Transaction Screens
(i)
Dog: Sale when r<c* - to stop an economic or cash loss (dog screen).
Gin Rummy approach unlikely to get attractive price if truly a dog.
27
FINANCE NOTES
(ii)
Star: Sale when r>c* - when NPV of remaining cash flows are less than
the sale price (star screen).
Note: Fit Test: firm must not only earn in excess of its Cost of Capital,
but also more than could be earned by an alternative owner:
(2)
Liquidation - asset sales with proceeds distributed to shareholders.
(3)
Spinoff - shareholders hold the same assets but in a different legal form (management
changes, but ownership remains the same). Shareholders receive a pro rata distribution
of separate equity claims on a subset of the original firm’s net assets; similar to stock
dividend
(a)
Benefits
(i)
Elimination of Cross Subsidies for Underperformers
(ii)
Best Used


When there is no natural buyer from whom a premium could be
obtained. Raise cash when subsidiary borrows to fund a special
dividend, then spinoff sub with debt (beware e.g. Lanier)
Notes: Distinguish from corporate dissolutions:
Spinoff: distribute pro rata subsidiary shares to shareholders
Split-off: exchange subsidiary shares for portion of parent shares.
Split up: subsidiary shares transferred to shareholder and parent
dissolves.
b)
(4)
M&A/Joint Venture
(5)
Sale leaseback - Need not own asset
(6)
Asset Securitization - LHS vs. RHS
Equity Restructuring
(1)
Going Private - Important incentive benefits (reduced agency costs) from combining
ownership and control/management.
(a)
Benefits - improved managerial incentives, superior monitoring expertise by
third party investors, reduced shareholder servicing costs, and increased debt
capacity utilization.
(b)
Costs - less access to public capital markets; balance costs and benefits of
public ownership; firms will find going private more attractive when they face a
decline in profitable growth opportunities which reduces the value of access to
the public capital markets.
(c)
Forms
(i)
Creeping tender/stock repurchase - long-term program of debt
financed stock repurchases that increases management’s proportionate
ownership
(ii)
Recapitalization (25% test) - insiders/management’s shares are
effectively split thereby, diluting public shareholders’ interests. The
28
FINANCE NOTES
public shareholders are compensated for the dilution by a tax advantaged
cash distribution. Used by firms to avoid criticism of LBO unfairness to
avoid triggering change in control auction e.g. RJR/Sealed Air.
Note: negative book equity.
Note: cash distribution usually equal to market price with implied stub
value: cash distribution ÷ (mgmt. shares - public shares).
(iii)
LBO - management with third party equity investors take the firm
private using the value of a firm’s assets as security, and the firm’s
operating cash flow and planned asset sales to service the debt.
Note: Recap vs. LBO
(iv)
Recap
LBO
Liquidity
Remain
Public Private
Change of Control
No
Yes
Accounting
Debit Equity
Purchase Act.
Taxes
Flexible
Capital Gain
Distribution
Market Price
Premium
Equity Carve Outs - partial public offering (PPO) whereby firm sells a
minority interest in a previously wholly owned subsidiary (e.g.
Amex/Shearson). Differs from spinoff because of cash sale to outside
investors. Creates independent market valuation of subsidiary
performance and achieves better fit of financial instruments and
incentives with unit’s cash flow.
(a)
Usually: results in complete sale of unit within 5 years i.e.
temporary structure
(b)
Types:
Primary - Subsidiary sells shares with proceeds retained; positive
market reaction.
Secondary - Parent sells subsidiary shares with proceeds retained
by parent; negative stock market reaction. IBP/Occidental
(c)
Best for: small, rapidly growing dissimilar subsidiaries because:
(i)
reduced risk of cross subsidies
(ii) increased monitoring
(iii)
(v)
more precise financing.
Return Capital to Shareholders.
(a)
Dividends
(b)
Stock Repurchase
29
FINANCE NOTES
(vi)
Leveraged Equity Purchase Plan
(vii)
Targeted Stock: used as spinoff alternative - tax, cost, credit;
(a)
Same Board
(b)
Single tax return
(c)
Co-Insure
(d)
Less impact
(viii) Creation of Special Purpose Entities - Structures, such as project
finance, joint ventures, LBO partnerships, MLP’s and R&D partnerships
have a specific limited purpose that reduces cross subsidies and improves
monitoring. They reflect the reluctance of investors to grant the privilege
of permanent capital to create real asset closed end mutual fund that
suffers from management as an off balance sheet liability.
c)
Restructuring Conclusions - Focus on improving value through either change in strategy or
financial restructuring. Firms failing to voluntarily restructure will have an external
restructuring imposed on them via a hostile takeover, an internal restructuring imposed by the
Board of Directors or a product market failure.
(1)
(2)
Common Restructuring Elements
(a)
increased leverage - increased debt financed stock repurchase as a means of
acquiring control. Discipline of debt impact.
(b)
improved asset efficiency - r = f (Ato, PM) = ≥ asset sales and cost cuts.
(c)
improved accountability - with more streamlined entrepreneurial organization.
(d)
better incentive systems - better tailored to results.
(e)
increased return of funds to shareholders.
Restructuring Signals
(a)
Multiple SIC’s = > number of unrelated SUB’s
(b)
Profitable Low Return Units ⇒ r ≤ c*
(c)
Positive FCF ⇒ reinvestment risk
(d)
Multi - Layered /Complex Organizational Structure ⇒ poor incentives
(e)
Unused Debt Capacity ⇒ wasted asset
30
FINANCE NOTES
(3)
Financial Restructuring Alternatives & Analysis
Proactive
Tactical
Strategic
Financial







Sale of block
Joint venture
Acquisitions
Leveraged
acq. Vehicle
Divestitures
Leveraged
disposition

Divestitures
Acquisitions




Voting provisions
Staggered board
Poison pill


Reactive
(4)








Stock repurchase
Block repurchase
Voting provisions
Poison pill
Sale of block
White squire
preferred





Monetise
undervalued nonstrategic assets
Cost restructuring
ESOP
Spin off
LBO
Recapitalisation
– Full or partial
ESOP
LBO
Recap
Sale
Objectives driven by market
12,000
Redefinition of core business leads to spin-offs,
divestitures, etc. Search for growth through global
expansion. Consolidation in mature markets (“Dream
Deal”). Re-engineering applied to targets
10,000
8,000
Dot Com
Crash
Evolution of the
Conglomerate
6,000
Portfolio theory at corporate
level called into question
4,000
Strength through
diversification
2,000
Credit
bubble
Internal
restructuring
“right-sizing”
Going private:
• LBO’s benefit from low
valuation in public market
• Developing of high yield
M&A financing
Dot Com
Bubble
Break-up plays
Growth in
earnings from
cost cutting
0
1960’s and 1970’s
The Age of the Conglomerate
(5)
1980’s – The Age of
the Financial Buyer
Early 90’s –
Fixing the
Mistakes
Mid 90’s – Age 2000 – 2003
of the Strategic Correction
Buyer
2004 – ?
Spectrum of shareholder activity: increased shareholder focus on financial structure
and capital management and allocation
Aggressive capital
restructuring
Dynamic
shareholder activism
LBO recap
Proxy fight
management change
Passive equity
underperformance
31
FINANCE NOTES
LHS
Transaction
RHS
(value)
(A) Income / DCF
FOCF = NOPAT–(WCI + T +
CAPEX)
WACC
(Claims)
(A) Mechanics
Issues
Tax
(A) Concerns
Ratings targets
Market availability - menus
Ke – Rf x 2 or CAPM
Legal
IRR
Debt = ref rate + spread
Accounting
MDC
(B) Relative Value
Comps
Multiples
Trading
Transaction
(C) Breakup Value
Regulation
Focus
Form
Payment
(B) Purchase Price Multiple
(C) Value Allocation
Vp = PreBid Trading + Premium
Vr = PreBid value + Synergy
NVAs = Premium - Synergy
(B) Funded Debt Multiples (FDX)
(C) Framework
R/C – tied to BB
Senior (SDX)
TL/A (amortization tied to
projections)
3 – 4X FLL
0.5 – 1X SLL
T/LB
SDX - T/LA
Other Debt
FDX - SDX
Equity
PPX – FDX
Subject to IRR constraint
32